know your valuation for equity compensation (and avoid the perils of 409a)

MEMBER OF PKF NORTH AMERICA, AN ASSOCIATION OF LEGALLY INDEPENDENT FIRMS © 2010 Wolf & Company, P.C.

Know Your Valuation For Equity Compensation (and Avoid the Perils of 409A)

Exclusively for

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Introductions

• Scott Goodwin – Wolf & Company, PC– Member of the Firm– Technology Services Team Leader– TCN board of directors and program committee chair

• Alicia Amaral – Scalar Analytics– Managing Director, Boston office– Instructor of Entrepreneurial Finance, Tufts University– CPA and Certified Valuation Analyst, CVA– Past CFO

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Who is Wolf & Company?

• Boston based, regionally focused

• 18 owners and 190 professionals in three offices

• Niche focused– Technology Services Team

• Provide our clients with direct access to owner-level expertise

• Ability to grow with you

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Scalar Analytics

• 600+ valuations per year • Majority of clients backed by venture capital firms

and angel groups• Clients in virtually every industry• Work with all of the “big 4” audit firms and

countless regional firms

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Agenda

• Overview of stock compensation plans• Overview of IRC Section 409A• The who, what, why and how of valuations• Q&A

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Stock Compensation Overview

• Common forms of stock compensation– Founders shares– Options– Restricted stock

• Tax treatment

• Advantages and disadvantages

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Overview of IRC Section 409A

• What is it?• How does it impact stock compensation?• What is the worst that could happen?• What do you as an entrepreneur need to know to

stay out of trouble?• What are best practices at various stages of

development?

Standard of Value

• Fair Market Value– Assumes hypothetical buyer– This is standard for 409A (per IRS)

• Investment Value– Assumes strategic buyer

409A ≠ VC investment

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Investment Valuation for Start-Ups

• Discounted Cash Flow???• Berkus• Bill Payne Method• Risk Factor Simulation• Venture Capital Method

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David Berkus Method

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$500k for each• Good idea• Prototype

• Quality Team• Quality Board• Initial Sale

Value $0 to $2.5 Million

Bill Payne Method

FactorManagementSize of Opportunity/MarketProduct/ServiceSales ChannelsStage of BusinessOther

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Weight30%25%10%10%10%15%

100%

Rating 100 = Average, 100+ = above average, 100- = belowMultiply result by $1.75M

Bill Payne Method Example

FactorManagementSize of OpportunityProduct/ServiceSales ChannelsStage of BusinessOther

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Weight30%25%10%10%10%15%

100%

Rating125115110

70125

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Total37.5028.7511.00

7.0012.5012.00

108.75

Value = $1.75M * 108.75 = $1,903,125

Risk Factor Simulation Method

Risk FactorManagementStageFunding RiskRegulatoryManufacturingSales & MktgCompetitionTechnologyLitigationReputationalExit

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Risk Factor+$500k+$250k-$250k

0+$250k-$500k+$250k+$250k

$0-$250k+$250k

$250k

ValuationBase $1.75MRisk 250kValue $2.0M

Venture Capital Method

Determine the• Investor’s required rate of return (ROI),

and• Terminal Value (TV)

Work backwards to get valuation (Post $)

TV can be either exit or next round14

VC Method Example

• TV based on estimated revenues and/or Net Income in terminal year

• Example: – Estimated revenue in Year 5 is $40M– Average multiplier for industry = 2– So your estimated value of the company at the end of year 5

, or TV = $40M * 2 = $80M

*Note: Can also estimate TV based on Net Income and apply average P/E multiples

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VC Method Example

• ROI• Say I sell an investment for $100M that I

purchased for $20M. What’s my ROI?• Answer: $100M / 20M = 5x• Same as TV/Post$ = ROI• To solve for Post$: Post$ = TV/ROI

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VC Method Example

• Say in our example that investor needs a 20X ROI• Post $ = TV/ROI• Post $ = $80M / 20• Post $ = $4,000,000

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Three Valuation Methods

Formal Valuation Methods 409A

1. Asset Approach

2. Market Approach

3. Income Approach

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2. Market Approach

a) Recent securities transactions methodb) Comparable (guideline) public company methodc) Comparable transaction methodd) Industry-specific multiples

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2b. Market Example: Guideline Public Company Method

Data for similar public companies in same industry• Salesforce.com, Inc.• Concur Technologies, Inc.• Kenexa Corp.• LogMeIn, Inc.• Constant Contact, Inc.

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In thousands of dollars (000) LTM Revenue LTM EBITDA NTM Revenue NTM EBITDA

Venture Co. $6,812.0 ($6,337.8) $14,380.7 ($3,166.6)

Mean Multiple 5.0x 22.1x 4.0x 19.2x

Implied Enterprise Value $33,809.2 N/A $57,270.2 N/A

Average Enterprise Value $45,539.7

Plus Cash $4,441.9

Market Value of Invested Capital $49,981.6

Steps in the Valuation Process

1. Take weighted average of applicable methods (asset, market or income) to come up with enterprise value

2. Allocate the enterprise value among classes of stock

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Valuation

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Step 1 – Determine enterprise value using weighted average of applicable methods (Asset, Market and Income)

Fair Market Value of Venture Co. as of September 30, 2012 Market Value of Method Weighted

In actual dollars Invested Capital Weighting Value

Adj. Book Value of Assets (Cost) $5,914,647 0.0% $0

Invested Capital (Cost) $22,182,037 0.0% $0

Recent Securities Transaction Backsolve (Market) $42,932,012 25.0% $10,733,003

Public Comps Valuation (Market) $49,981,604 25.0% $12,495,401

Acquisition Comps Valuation (Market) $55,094,153 25.0% $13,773,538

Discounted Cash Flow Valuation (Income) $44,606,522 25.0% $11,151,631

Weighted Market Value of Invested Capital $48,153,573

Less Debt ($1,750,000)

Weighted Equity Value $46,403,573

Step 2: Allocation

• Simply means “who gets what” in the event of an exit

• Common shareholders get paid after preferred

Remember that the purpose of 409A is to value common stock

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Option Value Analysis Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10

Definition: Before this breakpoint… Series C

liquidation

preference

Series B & A

liquidation preference

Common

participates

Allocated options

exercise

Series A converts to

common

Common

Warrants

exercise

Unallocated

options

participate in

value

Series B converts

to common

Series C reaches

3.0x

participation cap

Series C converts

into Common

stock

Break Points $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity

Current Equity Value (Price) $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573 $46,403,573

Exercise $0 $20,771,210 $22,182,037 $25,812,886 $27,793,293 $28,582,104 $39,428,548 $56,429,660 $301,546,405 $421,162,792 Infinity

Riskfree Rate 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31% 0.31%

Maturity (in years) 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0 3.0

Volatility 54% 54% 54% 54% 54% 54% 54% 54% 54% 54% 54%

d1 28.942 1.333 1.264 1.103 1.025 0.995 0.654 0.275 (1.501) (1.855) 0.000

d2 27.998 0.389 0.320 0.159 0.081 0.051 (0.290) (0.669) (2.445) (2.799) 0.000

Call Option Value: $46,403,573 $28,763,403 $27,871,048 $25,735,075 $24,660,647 $24,249,313 $19,421,999 $14,152,891 $929,712 $405,738 $0

Incremental Option Value $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738

Option Value of Security Option 1 Option 2 Option 3 Option 4 Option 5 Option 6 Option 7 Option 8 Option 9 Option 10

Series C $17,640,170 $0 $488,775 $204,543 $67,632 $795,364 $799,205 $1,933,391 $0 $60,031

Series B $0 $697,195 $0 $0 $0 $0 $0 $414,235 $19,010 $12,542

Series A $0 $195,160 $0 $0 $40,566 $229,734 $230,844 $566,020 $26,281 $17,340

Common $0 $0 $1,647,197 $689,319 $227,924 $2,680,416 $2,693,361 $6,604,011 $306,632 $202,309

Allocated $0 $0 $0 $180,567 $59,705 $702,136 $705,527 $1,729,925 $80,322 $52,995

A Warrants $0 $0 $0 $0 $15,507 $87,821 $88,245 $216,372 $10,046 $6,628

Common Warrants $0 $0 $0 $0 $0 $331,842 $307,524 $754,035 $35,011 $23,099

Unallocated $0 $0 $0 $0 $0 $0 $444,402 $1,005,190 $46,672 $30,793

Total $17,640,170 $892,355 $2,135,972 $1,074,429 $411,334 $4,827,313 $5,269,108 $13,223,179 $523,975 $405,738

Total Option Value Option Value Total Shares

Share Value

(Marketable)

Marketability

Discount

Share Value (Non-

Marketable)

Series C $21,989,112 5,934,632 $3.705 0.0% $3.705

Series B $1,142,982 1,239,906 $0.922 0.0% $0.922

Series A $1,305,945 1,714,171 $0.762 0.0% $0.762

Common $15,051,167 20,000,000 $0.753 35.7% $0.484

Allocated $3,511,178 5,239,012 $0.670 35.7% $0.431

A Warrants $424,620 655,276 $0.648 35.7% $0.417

Common Warrants $1,451,511 2,283,567 $0.636 35.7% $0.409

Unallocated $1,527,057 3,044,179 $0.502 35.7% $0.323

Total $46,403,573 40,110,742

Summary

• STEP 1Enterprise Value $48,153,573Less Debt (1,750,000)Equity Value $46,403,573

• STEP 2Allocation to common $15,051,167Divided by # shares ÷ 20,000Price per share = $0.753

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Discount

• Discount for lack of marketability (DLOM) 25 – 45%

• Discount for Venture Co. = 35.7%• Price per share $0.753 less 35.7% =

$0.484 per share

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Other Points

• Value is based on a number of assumptions that have a material impact on the result– Projected cash flows– WACC– DLOM– Comparable companies

• Important to have a “DEFENDABLE VALUE” (IRS and auditors)

• Important to review report for reasonableness of assumptions. You know your business.

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QUESTIONS AND ANSWERS

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Thank You!

Scott Goodwin, CPAsgoodwin@wolfandco.com(617) 428-5407

Alicia Amaralalicia.amaral@scalaranalytics.com(617) 684-5510

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Resources

To be posted to TCN website:

• Detailed outline and PowerPoint presentation• Scalar Analytics – white paper, “Section 409A – Common

Stock Valuation”